With the introduction of draft legislation to legalize marijuana by July 2018, the Liberal government is moving forward on its election promise. But as lawmakers polish the legislation to promote the best policy outcomes, they face a key challenge — they must ensure that any new tax measures encourage marijuana producers, distributors and sellers to become tax-compliant.

In terms of tax policy, Finance Minister Bill Morneau has wisely urged his provincial counterparts to keep taxes low on legal pot. As discussed in a report by the Office of the Parliamentary Budget Officer, if taxes are too high, then consumers will continue to use the black market. That’s a problem given more than 300 organized crime groups in Canada currently generate roughly $7 billion a year in illegal weed.

To keep the market out of the hands of the mob, the government should also reject “sin taxes” on marijuana. Those high taxes slapped on alcohol and cigarettes already encourage a black market in booze and smokes worth billions of dollars a year.

Instead, pot sales should only initially be subjected to the Harmonized Sales Tax (HST) at a total combined rate of 12 per cent to 13 per cent (with the federal Goods and Services Tax rate of five per cent and an average provincial sales tax rate between seven and eight per cent). The federal government should top up its five per cent Goods and Services Tax by an additional seven per cent to share revenues with provinces that don’t have a provincial sales tax (Alberta, for example) or have a separate one that is not harmonized with the HST (like British Columbia).

But even this low-tax strategy will fail unless the new regulatory regime allows for the development of a vibrant and innovative market. Here’s the main problem: Canada’s licensed medical marijuana companies — Big Pot — currently produce less than five per cent of the marijuana consumed by Canadians. The rest is provided by the black market.

Legal producers face high costs

The current licensing system was designed by Health Canada. It’s meant primarily to promote a product that is safe for consumption, encourages high costs due to the need for independent lab testing, quality control measures, mandatory usage of green energy sources and so on. Many of the Big Pot producers are now the largest legal marijuana companies in the world. They devote significant resources to comply with stringent regulations to produce lab-quality medical marijuana.

But for smaller players, the regulations throw up barriers to entry for new businesses and reduce the potential marijuana supply for the prospective legal market.

A parliamentary budget watchdog has said that tax revenues arising from marijuana sales will be modest when legalization first takes hold – hundreds of millions of dollars, rather than billions.THE CANADIAN PRESS/Ron Ward

This is unfortunate, because the black market has shown signs of business savvy that would warm the heart of Adam Smith. In cities like Toronto, Ottawa and Vancouver, consumers can subscribe to online social networks run by marijuana suppliers offering bulk discounts, frequent flyer points, locally produced products, taste tests, home delivery by bike courier and product bonuses when a subscriber brings a new consumer to the network.

These black market businesses, including dispensaries and marijuana collectives, are taking advantage of the fact that, with legalization on the horizon, police are generally not investigating small-scale illegal pot producers or laying charges against them.

Under the draft legislation tabled by the Liberal government, most of these innovative businesses will be shut out of the legal market. That’s despite the fact they offer the only possibility of filling the demand for legal marijuana. Moreover, these new businesses are so far ahead of the current state of play in the marketplace that many consumers will continue to use their convenient and superior services instead of dealing with Big Pot’s licensed producers and tightly regulated future retailers.

Non-compliance could become commonplace

Yet these smaller illegal pot businesses will be reluctant to follow their legal obligation to assess, collect and remit the HST to the Canada Revenue Agency because doing so would flag their illicit activities to law enforcement. To avoid getting charged with tax evasion, a non-compliant pot business could hire a tax lawyer and file a tax return with an anonymous Taxpayer Identification Number showing all taxes on pot sales were paid or collected. Few businesses, however, are likely to follow this route, and so non-compliance with tax laws may become widespread.

Keeping initial taxes and compliance costs low will encourage tax compliance. If marijuana businesses are permitted to thrive in a legal environment, they will be far more likely to pay their taxes. And once they comply and become part of the taxation system, then they’ll continue to bring in revenues to bolster federal and provincial coffers. That, in turn, should create a virtuous cycle as the new revenues can be directed at education and youth prevention as well as addiction treatment.

Whatever the solution, the government needs to keep any regulations flexible so that it can monitor results and, if necessary, modify the rules to promote the best possible policy outcomes, including potential future tax hikes.